Dresdner Kleinwort Wasserstein is offering an equity volatility arbitrage strategy that takes advantage of the fact that the implied volatility of the S&P 500 index is generally higher than realized volatility. The strategy, which is set up like a three-year note, partially invests in a zero-coupon bond to guarantee principal, while the rest is invested in a leverage account that's used to buy one-month variance swaps, according to marketing material from DKW.
The buyer of a one-month variance swap, an over-the-counter derivatives contract, bets that the predicted volatility of the S&P 500 index over the course of one month, as measured by the Chicago Board Options Exchange Volatility index (also known as the investor fear gauge), will be higher than the actual realized volatility of the S&P 500. The payout formula on the swaps is based on the difference between the strike volatility and the realized volatility.
DKW's back tests over the past 16 years found a 9.1% average annualized return for the strategy, and an average annualized volatility of 2.3%. The new product will be offered directly to hedge funds, money managers and other institutional investors.
